Can you improve on the 60/40 stock/bond allocation without changing the 60/40 allocation?

The classic 60/40 stock bond mix has proven to be a good core asset allocation. When in doubt, employing the simple 60/40 (SPY/AGG) asset mix as a base case has been an allocation that has performed well versus other diversification strategies. This allocation bias may be coming to an end. 

The gains from holding a US focused large cap equity and diversified bond allocation and not being further diversified across investment risk premia styles and international equity and bonds is a function of the recent performance and not special characteristics. Performance for both stocks and bonds is now off from the norms of the last decade. The correlation between stocks and bonds is moving higher. Volatility across equities and bonds is also trending higher. Something more defensive may be helpful.

Nevertheless, many investors are looking for a way to get defensive without a significant change to the asset allocation. There are simple defensive changes that can stick to a 60 percent domestic equity allocation and receive significant diversification benefit. Using the advantages of alternative index construction or smart beta can be a helpful simple strategy. (See Defense Beyond Bonds: Defensive Strategy Indices from SPGlobal.)

Smart beta strategies have performed well over a long period, but a better testimony of their current value will be with their ability to provide defensive benefit in a downturn. For those that want to maintain asset allocation and are not believers of active discretionary manager in any regime, the smart beta choices can offer some equity risk protection. First, the smart beta choices will change the mix of equity exposure, generally broadening the exposure away from large firms with momentum. Second, smart beta can focus on preferred characteristics like quality or low volatility that should provide defensive benefits.  

A tilt to long-only risk premia and away from market cap indices can preserve risk allocation while providing defensive characteristics. The same can be done with fixed income through reducing duration while maintaining credit exposure. A traditional 60/40 asset mix can be converted into a defensive 60/40 allocation. 

Fixed income choices - Move to further underweight

Current views on asset allocation in fixed income and credit are generally negative. The focus should be on holding shorter duration and cash investments. 

Credits spreads are widening because of both increased economic and financial risks. International bonds both DM and EM are facing dollar funding risks and slower growth. Long duration Treasury bonds show high risk even with recent rally. Underweight market allocation and risk weighing in fixed income and credit.

Spread widening can be costly - All is not well in credit land

It does not take much for an investor to have a losing credit trade on long duration bonds. The average duration on a long-term 10-year corporate is around 8 and current OAS spreads for triple-B corporates are 160 over Treasuries up from 120 earlier in the year. Half this move will take investors  back to levels seen in 2016 and wipeout all of the spread compensation for a year. This is not an extreme bet if we have any further erosion of equity prices or change in credit risk expectations, (See Corporate debt growth has exploded - The added macro shock sensitivity creates real risks.) Shorter duration corporates will be at less risk given their lower duration but the stocking up of credit for yield reaching can be painful if credit risks increase.  

Even if investors hold the bonds for the longer-run, the marking to market will impact portfolio values. Holding less risk and moving to cash is a valid alternative, but this will place any investor at a severe disadvantage of reaching return targets. 

Portfolio protection is critical, so holding alternative defensive strategies need to be replenished. Any futures or derivative swap product may still allow investors to receive the risk free rate with excess returns associated with other risk premia beyond credit. The amount of excess returns from alternative risk premia can be dialed to a level of volatility that can match bond risk. 

Credit investing was an effective investment choice when rates were headed lower, spreads were higher, and the economy was improving. A new environment of late business cycle risks, falling equity values, Fed tightening, and spread widening requires different thinking.

No diversification in Mudville - Time to try different risk premia styles

Diversification is usually thought of as a longer-term concept. Don’t worry if it seems like you are not receiving diversification in a given month or quarter. Think about diversification across a longer horizon.  Diversification also does not guarantee better returns for a portfolio. Negative diversification does mean that your losers will be offset with winners.

Yet, investors often look for diversification protection over short periods. If stocks are going down this month, they are looking for an offset this month. If stocks have had a bad quarter, investors are looking for something good this quarter. That is wishful thinking. Correlations change and the measure is about co-movement relative to mean values.

This year has not been good for diversifying assets like fixed income. Our simple chart shows returns for equities and some of the leading fixed income alternatives: the Barclay Aggregate, mortgages, long duration Treasuries, investment grade credit, and high yield. None have worked well at portfolio protection even though fixed income volatility with the exception of long duration Treasuries is less than half of equities. Investors are taking on a high degree of credit and rate risk during Fed tightening late in the business cycle. 

An alternative form of diversification is to breakout of asset class risk and switch to style risk that is focused on alternative risk premia. The concept of alternative risk premia is to isolate the risk within an asset class to some constituent components like value, carry, or momentum. This diversifies risk on another level beyond asset class or beta exposure. When blended across a number of premia, this diversification can be done with or without making a focused class decision.